"Fannie Mae ... is efficiently and effectively delivering
billions of dollars each year in benefits to the low- and
moderate-income home buyers Congress intends to help, at absolutely
no cost to the taxpayer."

"Using [government-sponsored enterprise] status to enhance
the credit quality of the enterprises provides Fannie Mae and
Freddie Mac with savings in funding costs worth billions of dollars
each year ... economic benefits are being transferred that are
equivalent to those provided by writing Treasury checks."

Congressional Budget Office Study
May 1996

How can one viewpoint hold that a federal program is costing the taxpayers
nothing, and another insist that the cost reaches in the billions
of dollars per year? Obviously, each party is interpreting the same
set of facts in different ways. In this case, Fannie Mae and Freddie
Mactwo agencies created by the federal government to make funds
available for home loanshave an incentive to convince Congress
that their efforts have no cost to the taxpayer. However, the agencies
are getting a valuable taxpayer resource for free, namely: the federal
government's implicit credit standing, something for which competing
firms would gladly pay.

The agenciesone with roots in the 1930shave evolved
into stockholder-owned and privately managed companies. But Fannie
and Freddie, which purchase mortgages from lenders, are not completely
privatized: Taxpayers, not investors, would likely bear the burden
of Fannie and Freddie's debts if the two firms could not repay them,
even though taxpayers are not legally liable. Together, the potential
financial responsibility of taxpayers is substantial. Fannie and
Freddie financed about 36 percent of all one- to four-family housing
debt outstanding as of March 1996more than the entire commercial
banking system.

There are questions about whether the current arrangement with
Fannie Mae and Freddie Mac is the most effective method to aid potential
homeowners. But these questions do not have obvious answers. Unfortunately,
there is much uncertainty surrounding the performance of the two
agencies. Analysis is difficult because the picture is often not
clear.

This uncertainty is not uncommon with federal programs. In every
program there is at least a minimum of uncertainty about its efficacy
it is an unavoidable result of any federal interventionbut
such small levels may simply be the cost of doing business. However,
uncertainty that pervades a program should bother the public and
policymakers; after all, federal intervention almost always involves
the use of taxpayers' resources. The need for review is not always
apparent, though, because a program's design may highlight its virtues
while downplaying its true performance.

Fannie and Freddie provide a good case study to explore uncertainty
in federal intervention. The agencies' circuitous subsidy transmission
is outside the control of the federal government; as a result, policymakers
have a hard time discerning if Fannie and Freddie pass almost all
of the subsidies to borrowers or if the agencies retain a significant
portion. Also, the indirect delivery of the federal subsidies hinders
analysts' ability to determine if Fannie and Freddie add value by
offering new products and services.

This uncertainty would not raise red flags if the enterprises
were sure to pass on their federal benefits to borrowers. In reality,
Fannie and Freddie's orientation toward profit-making creates a
strong incentive to retain some of the subsidies, although the ability
to act on this incentive is tempered by Fannie and Freddie's housing
responsibilities and limitations on their activities.

For the public and legislators, then, the questions of uncertainty
surrounding Fannie and Freddie regard the efficiency of using the
agencies to transfer a subsidy that is intended to benefit home
buyers: Can Congress or the public really feel comfortable with
Fannie and Freddie's use of their resources? Does the apparent success
of Fannie and Freddie mask deeper uncertainties about the agencies?
Is there a better delivery system for the subsidies?

The road to uncertainty ...

Fannie and Freddie's claims of costless benefits are suspect. They
make this claim because the benefits do not involve explicit transfers
of cash. However, taxpayers also incur costs whenever valuable public
goods and services are provided by the government to beneficiaries
for free or at a discounted price. The following hypothetical example
illustrates this point: Mr. and Ms. Olson go to a local bank to
apply for a loan to renovate their home. After reviewing their application,
the loan officer informs the Olsons that she will only make the
loan if they offer their car as collateral and pay a fairly high
interest rate. The bank is concerned, she explains, that the Olsons
will not have the resources or the desire to repay the loan.

As they trudge away from the loan officer's desk, the Olsons pass
a brochure touting the federal government's brand new "Cosigning
for America" program. Under this program, the couple reads,
the federal government will cosign any home renovation loan without
any charge to the borrower. That is, the federal government will
repay the loan to the bank if the borrower(s) cannot. With completed
brochure in hand, the Olsons return to the loan officer who now
agrees to approve the loan at a very low interest rate and without
requiring collateral. The bank knows that the ability of the federal
government to repay the loan is unquestioned.

Has the federal government given the Olsons anything of value?
Yes. Without the federal government's cosign, the Olsons would have
had to pay a higher interest rate and would have lost their car
if they defaulted on the loan. In fact, the Olsons would have paid
the government to cosign the loan.

Is "Cosigning for America" costly for taxpayers? Yes.
As noted, the federal government could have sold its cosigning authority
to the Olsons. The money raised by the sale of the cosigning could
have been used to reduce taxes. The giveaway of the cosigning has
a real cost to taxpayers even if the federal government never writes
a check under the program. This last point is worth repeating as
it often causes confusion. A program of free government cosigning
is costly to taxpayers even if all the borrowers with whom the government
cosigns repay their loans without government help. The cost arises
because the government is giving away a valuable service for which
borrowers would pay. The borrower is willing to pay for the cosigning
even before they start repaying the loan, as the benefits they receive
from the cosigningparticularly the more favorable interest
ratesare built into the terms of the loan.

A variety of firms sell the equivalent of "cosigning"
services. For example, many home buyers purchase mortgage guarantee
insurance. For a fee, these insurers will make up some of the shortfall
on the mortgage that the lender suffers if the home buyer defaults
and the sale of the property does not cover the loan.

... is paved with subsidies

Like the Olsons, Fannie and Freddie receive, and still benefit from,
valuable services and rights from the federal government. The federal
government exempts Fannie and Freddie from both state and local
income taxes on their earnings, and the costly registration process
of the Securities and Exchange Commission. But the biggest subsidy
Fannie and Freddie receive involves an implicit federal guarantee.
Investors believe that the special status and powers granted to
Fannie and Freddie by the federal government create an implicit,
but not legal, guarantee on Fannie and Freddie's financial obligations.
Investors have concluded that the federal government would almost
certainly pay them the interest and principal on Fannie and Freddie's
obligations if Fannie and Freddie could not. This perception is
not unintended. The obligations of Fannie and Freddie share many
characteristics with U.S. government securities. Moreover, the federal
government did not repudiate a similar implied guarantee of the
Farm Credit System when it had the chance in the late 1980s.

Fannie and Freddie benefit from the implied guarantee when they
borrow money. In some cases, they issue debt on the national capital
markets, use the proceeds to purchase mortgages from lenders and
hold the mortgages in their respective asset portfolios. This activity
is called portfolio lending. Both firms also fund mortgage lending
by securitizing mortgages (for example, acquiring mortgages, grouping
the loans and issuing a specialized type of debt backed by this
loan pool). The payments that homeowners make on the underlying
mortgages are used to pay the interest and principal owed to the
investors who bought the so-called mortgage-backed securities. Fannie
and Freddie guarantee the payment of principal and interest on the
mortgages underlying the mortgage-backed securities.

The implied guarantee is valuable because it substitutes the federal
government's ability to repay debt in place of Fannie and Freddie's.
This substitution, as was the case for the Olsons, reduces Fannie
and Freddie's cost of raising funds because lenders will accept
a lower interest rate when they are virtually certain to get their
money repaid. Many private firms make money by selling their guarantee
of repayment to other firms that are not as creditworthy. In contrast,
the federal government gives away its implicit credit guarantee
to Fannie and Freddie. The amount of this implicit taxpayer coverage,
as of March 1996, was about $360 billion of one- to four-family
mortgages in Fannie and Freddie's portfolio and about $1 trillion
of outstanding guarantees on mortgage pools. By way of comparison,
these financial obligations were about equal to all the debt outstanding
of state and local governments and were equal to about 35 percent
of all outstanding Treasury securities.

Confusion about the cost of a subsidy is not limited to the case
of Fannie and Freddie. For years, policymakers claimed that the
provision of deposit insurance and other financial guarantees by
the federal government had no cost to taxpayers. These programs
lend themselves to uncertainty because nothing tangible is exchanged
between the government and the recipient and the ultimate cost of
the program may not become clear until far into the future, long
past the initial provision of the guarantee. However, even on a
superficial level, the subsidy of Fannie and Freddie is harder to
grasp than that of many guarantee programs because of its implicit
nature and the public ownership of Fannie and Freddie.

How big is the subsidy?

The initial murkiness engulfing the cost of Fannie and Freddie's
subsidy is exacerbated because Fannie and Freddie currently enjoy
more information on, and day-to-day power over, the federal subsidy
than Congress or the president. As the budget office of Congress
recently reported, policymakers cannot look to the federal budget
for answers on how much of a subsidy will be paid to Fannie and
Freddie; neither does any appropriations bill nor any other accounting
record measure the size of the federal subsidy.

In fact, the federal government does not set the size of the subsidy
it provides Fannie and Freddie each year; the magnitude of the subsidy
from the implied guarantee, for example, depends on the difference
between how much Fannie and Freddie would pay to raise money if
they did not have special status with investors (that is, their
true borrowing costs) and how much they actually pay with the perceived
credit support of the federal government. The size of the subsidy
also depends on Fannie and Freddie's outstanding obligations. The
weaker the financial condition of Fannie and Freddie, the higher
their true borrowing costs and the greater the subsidy provided
by the implicit guarantee. The more obligations the federal government
guarantees, the greater the subsidy.

The ability of Fannie and Freddie, rather than Congress, to manage
the size of the subsidy can manifest itself in subtle ways. Fannie
and Freddie can take on new risks, for example, by choosing to fund
mortgages through portfolio lending instead of mortgage-backed securities.
By issuing debt and holding mortgages, Fannie and Freddie may bear
the risk that interest rates will fall, thereby encouraging home
buyers to prepay their mortgages, possibly leaving Fannie and Freddie
with less income to repay the debt they have issued. The implied
guarantee practically, but not legally, shifts this risk to taxpayers.
In contrast, these risks are borne by investors when Fannie and
Freddie issue mortgage-backed securities. The greater the risks
taxpayers bear, the greater the subsidy they provide to Fannie and
Freddie. Thus, Fannie and Freddie can increase their subsidy through
the portfolio lending option.

It is much more difficult to quantify the subsidy than to describe
the activities that alter it. The quantification could require,
for example, an estimate of how much it would cost Fannie and Freddie
to raise money if they did not have the implied guarantee. One way
to try to get at the cost advantage of federal credit support is
to compare mortgage-backed securities or debt issued by Fannie and
Freddie with similar obligations issued by firms in the same general
lines of business as Fannie and Freddie but without their favored
status. But finding comparable companies and obligations and trying
to control statistically for the differences between Fannie and
Freddie and their comparable entities is, by definition, very formidable,
because Congress designed Fannie and Freddie and their obligations
to be unique. In addition, all estimates are highly dependent on
the time period under examination. The same method that found a
large subsidy in one period will find close to no subsidy in another.

These difficulties do not mean that estimates are a waste of time.
The Congressional Budget Office (CBO) provided useful information
when estimating that the value of the subsidy for both enterprises
was about $6.5 billion in 1995. But these are far from exact calculations.
They are better understood as educated estimates on the orders of
magnitude of the subsidy at a given time, that are subject to challenge
and reflect inherent measurement obstacles. Thus, while it may be
tempting from the onset to focus on estimates, policymakers may
be better served by considering the costs, and possible cures, of
their disadvantages in gathering information on and exerting control
over Fannie and Freddie's subsidy.

Who benefits from the subsidy?

Given that they do not set the size of the subsidy, it is not entirely
surprising that policymakers only vaguely know who benefits from
the subsidy. Certainly, Fannie and Freddie are the initial beneficiaries
of federal subsidies, and they claim to effectively pass the subsidy
on to home buyers. If Fannie and Freddie faced vigorous competition,
they would have no choice but to pass the subsidy to the firms from
whom they purchase loans. Because a very high level of competition
exists among mortgage originators, these firms would then pass the
subsidy to mortgage borrowers. If one originator tried to hold on
to the subsidy, another firm could gain an advantage by lowering
its prices by the full amount of the subsidy. Other originators
would follow suit to remain competitive.

However, there are some indications that Fannie and Freddie are
not subject to the type of competition that would force them to
pass the full subsidy on to originators. In their securitization
market, for example, Fannie and Freddie, in effect, vie only with
each other for business. Fannie and Freddie also report financial
performance, such as very high returns to shareholders, and market
valuations not entirely consistent with full competition. While
this evidence appears persuasive, the CBO reported in 1993 that
Fannie and Freddie's markets, even with only two competitors, could
theoretically generate competitive pricing and production.

It is difficult to determine how much of the subsidy goes to aid
the homeowner, even if one knew that Fannie and Freddie were not
subject to full competition. Some analysts have calculated the difference
in mortgage rates between those mortgages that fall below the conforming
limit and those that rise above in order to determine how much Fannie
and Freddie lower interest rates. Fannie and Freddie cannot finance
mortgages whose original principal amount exceeds the conforming
limit, $207,000 in 1996. These calculations find that Fannie and
Freddie lower interest rates on conforming loans by about 0.3 percentage
points (from 6.3 percent to 6 percent, for example). But, the complexity
in trying to separate out how the conforming status affects the
cost of a mortgage, all other variables being equal, makes the estimate
of reductions in mortgage costs uncertain.

Nonetheless, analysts try to figure out how much of the subsidy
actually goes to borrowers by combining their estimate of the size
of the subsidy with estimates of how Fannie and Freddie's activities
affect interest rates on home loans. Through such a calculation
the U.S. Treasury found that about two-thirds of the total subsidy
went to borrowers, while Fannie and Freddie retained about $1.9
billion in 1995. The Treasury notes, however, that "Although
estimates ... give a general sense of the magnitude of the subsidies
involved, no single point estimate should be viewed as a firm indicator
of the benefits [Fannie Mae and Freddie Mac] receive or pass through.
The calculations ... omit important elements of both benefits received
and benefits passed through."

One should not equate the U.S. Treasury's imprecision with the
notion that it overestimated the retained subsidy; rather, the imprecision
itself is the point. The uncertainty of the calculations means that
Congress is always going to face challenges in distinguishing between
years when Fannie and Freddie pass on almost all of the subsidy
from the years when they retain much of the subsidy. As the CBO
acknowledged even while presenting its own estimates, "...
the complexity of operations conducted by [Fannie and Freddie] and
the proprietary nature of information about their business combine
to make it almost impossible for the Congress to be sufficiently
well informed about the conduct of Fannie Mae and Freddie Mac."

Again, Fannie and Freddie are not entirely unique. There are a
number of cases in which it is difficult to determine who ultimately
benefits from a federal subsidy. Firms and households that receive
subsidies, and the firms and households they interact with, will
change their behavior in ways that make it difficult to determine
who exactly receives the economic benefits of the subsidy. The difficulty
in analyzing the distribution of benefits, however, is not equal
among all programs. The more hands through which the subsidy has
to pass to get to the intended borrower, for example, the more difficult
it will likely be to determine the distribution of benefits. A subsidy
that travels from the federal government to the staff and owners
of Fannie and Freddie to mortgage bankers to home buyers via the
capital markets is passed quite often.

Do Fannie Mae and Freddie Mac add value
beyond subsidy transmission?

When evaluating the performance of Fannie and Freddie in meeting
their policy objectives, policymakers will need to consider Fannie
and Freddie's argument that they do not just deliver a subsidy.
Instead, they claim to create value for society through activities
such as developing innovative mortgages and investing in new technologies
that will reduce the cost of home purchases. Normally, the success
or failure of a product or service in the market signals if it is
creating value. The long-term willingness of consumers to buy, and
producers to provide, a product means it passes the market hurdle
and adds value.

The introduction of the federal subsidy fundamentally skews this
market test. Once any product is subsidized, it becomes difficult
to determine if its success reflects the inherent benefits consumers
derive from it instead of its below-market prices. Likewise, the
success of Fannie and Freddie's products and services may simply
reflect their subsidization by federal taxpayers rather than any
unique value the products or services provide.

There is one area in which Fannie and Freddie have added value:
Fannie and Freddie integrated national capital markets with local
mortgage markets, and thereby helped eliminate funds shortages at
a time when local and regional lenders could not raise enough money
to make all the home loans demanded by borrowers. But, even these
benefits created by Fannie and Freddie may not justify past and
current subsidies. Congress may have been able to reduce regional
funds shortages, in part, simply by revoking policies that limited
how much interest banks could pay to depositors and where banks
could operate. In addition, unsubsidized private firms could now
probably integrate local mortgage markets with national capital
markets.

Policymaking and uncertainty: Where to turn?

Policymakers may view the recent debate on estimates of how much
subsidy Fannie and Freddie retain as just one of many disagreements
among policy wonks. Reaching that conclusion, however, would relegate
legislators to a self-imposed and perpetual uncertainty about the
performance of Fannie and Freddie in meeting policy goals.

Policymakers may find the charters of Fannie and Freddie reassuring
in the face of this ongoing uncertainty. They may assume that, by detailing
the responsibilities of Fannie and Freddie to assist borrowers, the charters
will act as a beacon and guide Fannie and Freddie toward effective subsidy
provision. However, the financial incentives facing Fannie and Freddienot
just a vague charteralso guide their behavior. A legislator may
be willing to accept the uncertainty concerning one form of federal subsidy
transmission if the program's incentives ensure that the intended party
receives the subsidy. However, in this case, Fannie and Freddie have a
financial incentive to enlarge the amount of the subsidy they receive
and retain.

How would we expect Fannie Mae and Freddie Mac to act?

Like other for-profit firms, Fannie and Freddie have one overriding
incentive: to maximize profits. These incentives result directly
from the organizational form and legal status of Fannie and Freddie.

According to Fannie Mae's 1995 annual report, its "... mission
has been to provide financial products and services that increase
the availability and affordability of housing for low-, moderate-,
and middle-income Americans." Yet, management of Fannie Mae
or Freddie Mac cannot, over the long-term, simply allocate resources
to the worthwhile cause of its choice. After all, these firms are
owned by shareholders. What drives these owners of Fannie and Freddie?
While Fannie and Freddie's shareholders do not have an official
mission statement, their unofficial motto might read something like,
"We demand the highest return available on our investment for
our level of risk tolerance." The owners' creed does not make
shareholders an avaricious lot, unsympathetic to the cause of housing
availability and affordability. Rather, enterprise owners, such
as several Fidelity mutual funds and Warren Buffet's Berkshire Hathaway,
have a duty to their own shareholders to maximize value.

When the activities of Fannie and Freddie conflict with shareholders'
goals, the owners would try to influence managementeven install
new managementto bring corporate behavior in line with shareholder
objectives. For example, shareholders of the Student Loan Marketing
Association (Sallie Mae)a firm organized like Fannie and Freddie
to increase funds for student loanssuccessfully installed
eight dissident members to its board of directors when management
sought to cut ties with the federal government. This step would
have reduced the ability of shareholders to benefit from the federal
subsidies Sallie Mae receives.

If Fannie and Freddie continually engaged in activities that did
not maximize profits, their shareholders could sell their stock
and drive down the value of Fannie and Freddie's stock. A reduction
in the value of enterprise stock would directly affect senior management,
who receive some of their compensation in the form of stock. The
potential for unpleasant shareholder actions gives Fannie and Freddie
a long-run incentive that should differ from their mission statement
in one crucial aspect: Fannie and Freddie will increase the availability
and affordability of housing but only in a manner that maximizes
shareholder returns. Alternative scenarios in which these investors
willingly give up returns on their investments, or are systematically
duped by Fannie and Freddie for long periods of time, seem less
plausible.

Shareholders' objectives seem to give Fannie and Freddie a significant
business incentive to treat their federal subsidy as another tool
to increase profits. We should thus expect Fannie and Freddie to
retain portions of the subsidy. We should also expect Fannie and
Freddie to try to increase profits by expanding the activities in
which they deploy the subsidies and gain market dominance. Analysts
have reported behavior consistent with the expanded deployment of
the subsidy.

Freddie Mac's use of debt to fund mortgages offers an interesting
example of how shareholder ownership could influence enterprise
behavior. As previously noted, Fannie and Freddie can increase their
subsidization, and thus increase returns to shareholders, through
portfolio lending. During the 19 years prior to its change in ownership
status, Freddie Mac did not engage in much portfolio lending. Its
mortgages in portfolio increased from zero to about $21 billion
in that period. In the six complete years from 1990 to 1995, following
the conversion to public shareholder ownership, mortgages in portfolio
increased from about $21 billion to about $108 billion.

This incentive does not mean that Fannie and Freddie's charters
are blissfully ignored, though; shareholders do not expect Fannie
and Freddie to exploit their subsidy in an unconstrained fashion
because they know that Fannie and Freddie must meet very specific
targets to assist a variety of home buyers, including those with
lower incomes. Fannie and Freddie face legal restrictions on the
types of activities in which they can engage. However, these restrictions
are not so severe relative to the benefits of their favored status,
so as to compel Fannie and Freddie to give up their federal charters.

Owners also realize that Congress may decide to eliminate the subsidies
to Fannie and Freddie if policymakers perceive that shareholders capture
too much of the subsidy. Shareholders want to avoid this threat because
a reduction of the subsidy means a reduction in shareholder wealth. For
example, Fannie and Freddie's stock price fell on Friday, Oct. 20, 1995,
after a senior congressman proposed levying a user fee on Fannie and Freddie
that would effectively reduce their subsidy. However, by the following
Monday the stock price was back up. According to Bloomberg Business News,
"... analysts all over Wall Street said that the user fee idea would
blow over and that investors should take the opportunity to buy ... "
Shareholders should be willing to give up some subsidy today to ensure
that they reap the benefits of subsidies into the future.

Reducing uncertainty: A direct alternative

Policymakers have many methods for providing housing subsidies.
A direct subsidy transmission from the government to targeted home
buyers would not suffer the same level of uncertainty or the same
incentives. The direct subsidy could take any number of forms: One
method would be to directly provide checksthat could be restricted
to housingto all qualified home buyers (those in a certain
income class, for example). Congress would annually appropriate
the funds for this program and enact rules on eligibility and the
percent of program costs that could go to administrative expenses.
If it so desired, Congress could require that private firmswhose
contracts reward them for cost-effectivenessdesign and operate
the program. Whatever its form, the cash flows of the direct subsidy
would be recorded in the federal budget.

Some analysts oppose the replacement of Fannie and Freddie's subsidies
with an appropriated subsidy, believing the switch will lead to
a reduction in housing subsidies. A restrictive budgetary climate,
they argue, would prevent Congress from approving the same level
of subsidies for a direct subsidy program that Fannie and Freddie
are believed to receive. But a housing subsidy whose survival depends
on being hidden from view, sheltered from budgetary constraints,
and shielded from comparisons with other uses of society's resources
should be re-examined.

A direct subsidy program would not be immune from uncertainty. It may
be difficult, for example, to determine how much of the subsidy benefits
landlords who raise prices in response to the new subsidy. However, the
direct approach provides a clearer and much more public framework with
which to analyze the variety of issues that all subsidy programs inevitably
raise.

Lessons learned

It is not always obvious if a federally subsidized intervention
achieves its goals. Of course, a little doubt about the effectiveness
of a government program is practically unavoidable. However, the
uncertainty concerning the effectiveness of a federal program can
be pervasive and inherent in the subsidy transmission vehicle policymakers
have chosen. Those cases deserve policymakers' and the public's
special attention, and Fannie Mae and Freddie Mac are examples of
such vehicles.

Upon closer inspection, there are at least two major implications
of using organizations like Fannie and Freddie to provide subsidies.

Policymakers will have weak control over the size and transmission
of the subsidies. As such, they will have an extremely difficult
time determining if the subsidies provided to Fannie and Freddie
actually find their way to the intended beneficiaries.

The owners of Fannie and Freddie provide their companies with
incentives to maximize the value of their stock. This incentive
can run counter to the efficient delivery of a subsidy.

The combination of an environment of uncertainty and this financial
incentive is a virtual formula for an inefficient use of taxpayer
resources. If so inclined, Congress could provide a direct subsidy
to homeowners and reduce the uncertainty associated with Fannie
and Freddie. At a minimum, these implications suggest that Congress
consider their ability to evaluate the effectiveness of a subsidized
program, and the incentives provided by the program, when determining
if it should be implemented.

Editor's note: One of Fannie and Freddie's most significant new initiatives
involves automating mortgage underwriting. A follow-up
article in the next issue of The Region will discuss
the uncertainty surrounding the potential benefits and costs of these
automated systems.